Central Counterparty Capitalization and Misaligned Incentives
61 Pages Posted: 13 Feb 2019
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Central Counterparty Capitalization and Misaligned Incentives
Central Counterparty Capitalization and Misaligned Incentives
Date Written: February 7, 2019
Abstract
Financial stability depends on the effective regulation of central counterparties (CCPs), which must take account of the incentives that drive CCP behavior. This paper studies the incentives of a for-profit CCP with limited liability. It faces a trade-off between fee income and counterparty credit risk. A better-capitalized CCP sets a higher collateral requirement to reduce potential default losses, even though it forgoes fee income by deterring potential traders. I show empirically that a 1% increase in CCP capital is associated with a 0.6% increase in required collateral. Limited liability, however, creates a wedge between its capital and collateral policy and the socially optimal solution to this trade-off. The optimal capital requirements should account for clearing fees.
Keywords: Central counterparties (CCPs), capital requirement, financial stability
JEL Classification: G01, G12, G21, G22
Suggested Citation: Suggested Citation